How Business Owners Can Avoid the New Investment Tax

Take an Active Role in Running the Enterprise, and Prove It to the IRS

Business owners can avoid paying a new 3.8% investment tax on their profits by taking on an active role in running the enterprise. But they need to document their workload and maintain that work level year after year, experts say.

The tax on net investment income, enacted as part of the Affordable Care Act, took effect in 2013. It is levied on dividends, capital gains and other investment income for most married joint filers who have more than $250,000 in adjusted gross income. (For most singles, the threshold is $200,000.)

The Internal Revenue Service imposes the tax on individuals who are the ultimate owners of entities such as partnerships and S corporations, whose income passes through directly to the owners, when it determines owners have more of a passive "investor" role—based partly on how much time they spend on the job. Active owners don't have to pay the tax on income from the business.

Financial advisers say clients are asking how hard it would be to go from being a passive owner to an active one. "This is not easy to do," says Katherine Dean, managing director of wealth planning at Wells Fargo Private Bank, which has $170 billion under management. "Don't try to convert passive activities if you are not seriously participating in the continuing running of the business."

To determine whether business involvement is active, the IRS uses a series of tests: Some business owners have to spend at least 500 hours on the job annually, though the owner of a small business may pass the test because he or she is its sole participant. The agency says it will look for records that show a person's work efforts have been "regular, continuous and substantial."

Ms. Dean recently worked with a client who owns two restaurants—established as S corporations—for which he acts as general manager. The client also owns a food-distribution business set up as a limited liability corporation.

She helped the client take advantage of a two-year window the IRS has allowed for 2013 and 2014 to let those who qualify regroup some activities so they can meet the test of being active. The IRS has approved how the client regrouped his activities in the restaurants, so he is considered as active in both.

A good place to start when thinking about becoming more active is to look at how close your income is to the threshold that triggers the tax, says Stephen A. Baxley, a managing director and director of tax and financial planning at Bessemer Trust in New York.

For someone who is close to the threshold, it could be worth it to spend more time in the business to meet the IRS test for material participation, he says.

Some kinds of businesses—such as those that involve rental real estate—make it harder for an owner to meet the activity test. Rental income is generally considered passive, Ms. Dean says. To be considered otherwise, an active owner also must qualify as a real-estate professional who spends more than 750 hours in services related to real estate, she says.

Cathy Schnaubelt, a wealth adviser in the Houston office of wealth-management firm Atlantic Trust, which oversees $24 billion, says business owners should maintain scrupulous records in case the IRS issues a challenge. The agency looks for signs that owners are stretching the truth about how much time they spend running a business.

A taxpayer who draws a paycheck for a 40-hour-a-week job in one city but claims to be an active participant in a business in another city may raise a red flag. Says Ms. Schnaubelt: "The IRS will ask, is that reasonable?"

"You need contemporaneous records that show you are really doing these things as they happen, versus making it all up after you get the audit letter," she says.

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